The College Debt Bubble (and Six Rules for 529 Plans)

Soaring tuitions are not your problem, parents of little ones. They are of zero consequence, given your timeline, so you can focus on other injustices like saving the whales, the honey bees, or the three-martini lunch (fast going out-of-style).

Runaway tuitions will plummet 66% to $3,000 annually for public universities long before your preschoolers take their SATs. With them will crash the salaries of countless administrators and real estate values in those cool little college towns.

How do I know this? It’s a classic credit bubble, and will end like they all do.

Why college costs are so high

In plain English, we threw a bunch of money at 18-year-old kids, told them they could only use it for college, and are surprised and confused that the price went up. Duh.

This is ECON 101, folks. Supply and demand (with a ton of unintended consequences and distortions, the hallmarks of regulatory interventions in a market economy).

Okay, pretend it’s “market day” at your child’s preschool, and Connor, Caleb, and your kid all get some chips (say five each) to trade and compete for cookies. A market price develops, cookies are exchanged for chips, and the game ends. Now start over, but give them all 100 chips each. What do you think happens to the price of cookies?

In a slew of misguided efforts first to offer GI benefits, beat the Russians to the moon, and then make college “affordable”, well-intentioned, vote-seeking bureaucrats determined the government should use taxpayer funds to underwrite student loans to anyone with a pulse, and to guarantee them in case of default, even for private lenders. To limit potential losses, students, arguably our most vulnerable and naïve demographic, were precluded from basic bankruptcy protection, thereby also removing a necessary cog in capitalism that ensures prudent evaluation of risk by lenders.

Atrocious (truly a perfect adjective for this act of brilliance).

That’s right; we took out all the little things that make lending and borrowing an effective vehicle for turning savings into productivity and economic growth. Wow.

Predictably, the student loan sector boomed. Risk was socialized, if not eliminated. Teenagers, fueled by propaganda and drunk on cockeyed optimism, were pushed out like wind-up toys, directed to borrow tens of thousands of dollars without collateral or even a discernible plan to pay any of it back. Off to Party School USA they went…

Worse, we convinced ourselves that the only ticket to a successful future is higher education, regardless of quality or cost. We failed to introduce children to the perils of debt and the marketability of skills.

What is a credit bubble?

Credit is money, issued as a loan. A bubble exists where too much lending and borrowing occur, above the ability for borrowers to repay. Caused by speculative fever, government intervention, or both, prudent risk-management is removed from underwriting.

You know about these. We just had one in housing (that they’re working now to re-inflate, the grand wizards at the central bank and their ringmasters in DC).

When you create money only for higher education and tell kids their choice is binary (prestige through a degree, failure and chagrin without), you drive up tuition. Colleges did what any business would when faced with millions of new customers flush with money to spend only on their services. They raised prices, and expanded capacity.

At $1.3 trillion in student loans outstanding, we’re up from $250 billion in ’03, a multiple of 5x in less than 15 years. Credit, meet bubble (“Hi bubble, want to make babies?”).

How does it end?

We’re turning out more watered-down college grads, with increasingly useless majors (thanks to all the extra capacity). That little piece of paper that once acted as an effective screening mechanism for employers doesn’t mean what it used to. Again, supply and demand. More supply (college grads), means lower prices (in the form of wages). Poor bastards, cap-and-gown in hand, are now forced to take jobs at Starbucks, living in mom’s basement, like modern-day indentured servants.

“Congrats, Timmy, you spent four (to six) years and $80,000 at a marginal institution to get a bachelor’s degree in gender studies”.

Who would hire these kids? Sure, you might hire and train them, in spite (not because) of their degree. How long can we delude our children into this terrible deal?

The good news is, the shit is hitting the fan. One in four borrowers is delinquent or in default. Kids, ill-educated and wide-eyed, victims of a rotten system, are now calling for government to pay for free college educations for all. “Great idea, Chip. Maybe unicorns can provide it?” Sorry, but (a) nothing is free, and (b) it was your well-intentioned and all-knowing government that made it so expensive.

The answer, instead, is as old as the act of lending itself. The loans must go bad, the lenders stiffed. Because of government-backing, the ones stiffed will be taxpayers. Banks will be bailed out, and kids may be forgiven of (some) debt. Maybe.

Universities will take it on the chin, but they gorged already on this bonanza. Capacity will be reduced, worthless majors and departments eliminated, bloated administrations downsized. The cranes will come down in college towns, but most of the beautiful campuses will remain (others sold and repurposed), an ode to another bizarre experiment with central planning, money printing, and groupthink.

Where will tuitions land? Historically, a university education at a private school costs about 22% of median household income, or $12,000 annually in today’s dollars. A public school is about 5%, or $3,000 per year.

Timing

Timing predictions are tough, and like any collapse in a crony system, this will be fought by pandering lobbyists for institutions that feed at the trough of student debt servitude. But kids and parents are waking up, and wages simply cannot keep up. Tuition loans of this size cannot be serviced. If they cannot be serviced, they will not be serviced.

The whole edifice has no choice but to collapse, and should within five years. Ten is a sure-thing. If your kids turn 18 before, remember, they have options. They’ll get more experience in the real world, starting a business, or taking a commission-only job in sales and spending $20 for two books (this one, then that one). They can learn a valuable trade with an apprenticeship, or get more value looking overseas for higher education.

If they opt for college in the US today, make sure they know the implications of debt, and marketability of skills. The experience and social components are wonderful, no argument.

I relish my years at the University of Colorado (Economics, 2000)…lifelong friendships forged, a gorgeous, sprawling campus at the foot of the Rocky Mountains, keg parties Thurs – Sat nights up and down the streets in student-rented homes on The Hill, Big 12 football Saturday afternoons at Folsom Field, beautiful girls everywhere, season passes at student rates to Vail, Copper and Breckenridge, camping, hiking, and summer afternoons swimming in Boulder creek…it was paradise. (I guess I didn’t mention class, but that was good too, and I picked up a few things). Go Buffs!

But, the world today is changing.

You can access courses from the best institutions in the world – Harvard and MIT – online for free. If you want to learn, it is easier and cheaper than ever, and your best ticket to success has always been hustle. Get up early, and outwork the competition. The demand for mediocre professors will drop like a stone, as will the cost.

6 Rules for 529s

Overpriced and debt-fueled tuitions are headed for the dumpster, then what about 529 plans? Cash out, or pinch pennies and save for Junior’s big shot at Indiana State?

Full disclosure: Ashley and I don’t have one (given my views, we have not made it a priority). I reviewed them again after a request by a reader to expand on my bubble comments in the previous post (specifically on implications for 529s).

Here’s the skinny: There are two types, college savings plans and prepaid tuition plans.

For reasons stated, avoid prepaid tuition plans. Tuitions will come down, so don’t lock in now. Plus, these limit your choices long before you want to tie your children down.

A 529 savings plan acts like a Roth IRA; contributions are not tax-deductible, but earnings inside the 529 (capital gains, interest and dividends) are not taxed, if used for educational expenses. Avoiding taxes on investment earnings can increase your total return substantially. A 529 plan is worth doing if you can meet these six rules-

  1. Before opening a 529, pay off credit cards and other high (or variable) interest rate debt, max out retirement benefits (company-matching 401ks, then Roth IRAs), and set aside a rainy-day fund of a few months living expenses, in case of emergency.
  2. Use a Savings Plan, not a Prepaid Tuition Plan, and choose carefully. You can use in-state or out-of-state plans. Some have high fees (this Forbes article is good).
  3. Don’t go overboard. Your money is captive, and your limited in what you can spend it on. Anticipate costs at half of today’s rates, which leaves a 40% cushion on my estimate. Once covered, put new money elsewhere. Don’t buy into advice that extrapolates tuition increases of the last 20 years, 20 years into the future. It’s impossible.
  4. Choose investments prudently; the 529 is a shell, and inside are investment options. Average into 3-4 mutual funds with low fees and diversification with regular (i.e. quarterly) deposits, for example, (a) emerging/international stocks, (b) US dividend payers, (c) a target date fund (aiming for your kids’ high school graduation).
  5. Unless you (or your financial advisor) are comfortable allocating to value (moving money between asset classes based on relative valuation), and have a good understanding of financial markets, just buy and hold.
  6. Hold 20-40% as a cash position (i.e. money market or T Bills), waiting for a panic. You want to be a buyer when there’s blood in the streets. Deploy this into your mutual funds when everyone else is selling (i.e. like the crash of ‘08 to ‘09).

Endnote

The stories are everywhere, and the handwriting is on the wall.

We all know people who maxed out borrowing and never graduated, or can’t find a job. Perhaps you’ve also seen the for-profit education sales-machine in action, rounding up veterans, lost-souls, and the homeless to fit with student loans.

This is what the end of a massive credit bubble feels like. There are cracks in the veil, and the sooner it ends, the better. The university system must return to serving a useful function at a reasonable price, so we can stop sending impressionable young minds out into the world jaded, hoodwinked, saddled with debt, and with poor life prospects.

We will look back one day soon and it will all seem crazy in retrospect. In the meantime, don’t ever think your children are worse off for starting their adult lives four years early, debt-free, and on the road less traveled. It could make all the difference…

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5 thoughts on “The College Debt Bubble (and Six Rules for 529 Plans)

  1. Bazaar and bizarre might sound alike but a bazaar is a market and bizarre describes something kooky. There could be a bizarre bazaar run by monkeys selling people feet.

    Like

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